67 partitioned but, rather, some assets went in their entirety to one spouse and some went in their entirety to the other. Not all transfers in community-property states were tax-free events, however. An exchange of separate (nonmarital) property for community property or an unequal division of community property resulted in taxation. Similarly, unequal divisions of jointly owned property in noncommunity-property states resulted in taxation.69 70 68 Davis thus required an examination of state law in order to determine whether the transferee of property had an existing property interest in the property received at the time of the transfer, notwithstanding that the transferor was titleholder to the property. If the transferee in a common-law state possessed an interest "similar to community property," such as was held under some "equitable distribution" statutes, the transferor might not realize a gain on the transfer and the transferee would take a carryover basis, even though the property was not in fact community property or jointly held. This reliance on state law enabled states to enact “antiDavis" legislation, exemplified by Oregon's statute: "Subsequent to the filing of a petition for annulment or dissolution of marriage or separation, the rights of the parties in the marital assets shall be considered a species of co-ownership and a transfer of marital assets ... shall be considered a partition of jointly owned property." The “equitable distribution statutes” of other states often were interpreted to vest a property interest in the transferee in the case of a “special equity" determination. These eleventh-hour vestings of property rights during the course of divorces in noncommunity-property states most often were upheld by the courts as effectively eviscerating Davis.72 67 68 Rev. Rul. 81-292, 1981-2 C.B. 158. See, e.g., Siewart v. Comm'r, 72 T.C. 326 (1979) (receipt by W of noncommunity cash and a personal note of H for transfer of her one-half interest in community property constituted a sale, not a division of community property); Carrieres v. Comm'r, 64 T.C. 959 (1975), aff'd, 552 F.2d 1350 (9th Cir. 1977) (per curiam) (taxable sale to W to the extent H used his separate property to pay for W's community property interest in stock but no taxable sale with respect to the portion of such stock exchanged for H's interest in other community property). 69 Rev. Rul. 74-347, 1974-2 C.B. 26. 70 See Cynthia Garrison Lepow, Proposals to Reform the Tax Treatment of Property Division Incident to Divorce-A Splitting Headache, 10 COMMUNITY PROP. J. 237, 250-53 (1983) (describing cases). 71 ORS 107.105(1)(f) (discussed in Laird v. U.S., 16 Cl. Ct. 441 (1989)). 72 See, e.g., Collins v. Comm'r, 421 F.2d 211 (10th Cir. 1969); Imel v. U.S., 523 F.2d 853 (10th Cir. 1975); Cook v. Comm'r, 80 T.C. 513 (1983), aff'd, 742 F.2d 1431 (2d Cir. 1984); Boucher v. Comm'r, 710 F.2d 507 (9th Cir. 1983); Bosch v. U.S., 590 F.2d 165 (5th Cir. 1979), cert. denied, 444 U.S. 1044 (1980); McIntosh v. Comm'r, 58 T.C. 4 (1986) (applying pre-1984 law); Laird v. U.S., 61 Cl. Ct. 441 (1989) (applying pre-1984 law). As stated above, this state of affairs resulted in much confusion and costly litigation under Davis, many traps for the unwary, and a variety of results for what appeared to be similarly situated taxpayers, depending on state law. It also resulted in a fair amount of whipsaw for the Federal Treasury, with the transferor spouse claiming a tax-free division of property and the transferee claiming a stepped-up basis under Davis on later disposition. This state of affairs remained extant until the law was amended in 1984. C. From 1984 to the Present 1. Activities Leading to the Tax Reform Act of 1984 In the early 1980s, the American Bar Association (ABA) Tax Section created the "ABA Domestic Relations Tax Simplification Task Force"73 to study and make recommendations regarding the taxation of transfers in divorce. It identified six criticisms in the law at that time, as follows: 1. That many of the exiting rules are overly complex, requiring a degree of tax 2. That some rules, although seemingly relevant in countless cases, are not 3. That, due to the significance of local law in this area, disparate tax results 5. That the overall domestic relations tax structure has produced, and continues 73 The members of the Task Force were David H. Hopkins (Project Coordinator), Berneice A. Anglea, Joseph N. DuCanto, Steven D. Kittrell, Robert H. Mnookin, Marjorie A. O'Connell, Gary C. Randall, Frank E.A. Sander, Thomas R. White, III, J. Nelson Young, and Michael J. Graetz (Liason with Tax Section Simplification Committee). See signatories to Preliminary Specifications for Simplification of Domestic Relations Tax Law, Technical Memorandum to the Report of the American Bar Association's Domestic Relations Tax Simplification Task Force, ABA Section of Taxation at 28 (May 17, 1981) (copy on file with author) [hereinafter Task Force Technical Memorandum]. This "Technical Memorandum" contained a more detailed description of the proposals more concisely summarized in American Bar Association's Domestic Relations Tax Simplification Task Force, Preliminary Specifications for Simplification of Domestic Relations Tax Law (copy on file with author) [hereinafter Task Force Preliminary Specifications]. 74 6. That there may be a significant degree of noncompliance with the applicable The "basic touchstone" guiding the Task Force's recommendations was the concept of "private ordering," under which "parties to a divorce or legal separation, via a written agreement, may set their own tax framework."75 As is discussed in more detail below, this idea was not carried out in the Task Force's proposals to the maximum extent possible and was largely rejected, with only one small nod to the contrary, in the legislation eventually enacted in 1984. 76 The Task Force made the following major recommendations with respect to the income tax treatment of transfers in divorce. First, it recommended that all in-kind transfers of property under a decree of divorce or written instrument incident to such a decree be nonrecognition events, with a carryover basis. In other words, the Task Force recommended 74 77 Task Force Technical Memorandum, supra note 73, at 1-2. 75 Id. at 2. 76 The Task Force also considered issues arising under the estate and gift tax, which are not considered in this paper. See id. at 26-28. 77 It recommended that nonrecognition be the norm, whether or not the property is encumbered with debt in excess of basis or incurred on the eve of the transfer in an effort to "cash out" the value while transferring the obligation to repay the encumbering debt to the transferee spouse. See Task Force Technical Memorandum, supra note 73, at 5. Under some other nonrecognition provisions, where one property is "exchanged" for another, debt in excess of basis, or debt incurred on the eve of transfer, may produce recognized gain on the transfer, notwithstanding the general nonrecognition rule to the contrary. See, e.g., I.R.C. § 357(b), (c). The gain produced under I.R.C. § 357(c) on transfers of property with debt in excess of basis is equal only to that excess amount, and that gain recognition is required solely to avoid the negative basis that would otherwise occur in the property received under the mechanical rules of I.R.C. § 358. There is no such "negative basis" problem in this context, since any property received in exchange takes its own "carryover basis" rather than a "transferred basis" that starts with the basis of the property given up and is reduced by any encumbering debt. Compare I.R.C. § 358(a)(1), (d) The gain produced under I.R.C. § 357(b) equals 100% of the transferred debt and is intended to dissuade transferors from "cashing out" the value of the property by encumbering it with debt shortly before the exchange and then transferring the obligation to repay the debt along with the property. Professor Gabinet has questioned whether this aspect of the section 357 approach ought to be extended to transfers in divorce. See Leon Gabinet, Section 1041: The High Price of Quick Fix Tax Reform in Taxation of Interspousal Transfers, 5 AM. J. TAX POL'Y 13, 37-40 (1986). My own view is that divorce is not a transaction, like the corporate reorganizations that are the subject of section 357, undertaken to cash out property appreciation without tax, and that the cooperation of the transferee spouse in accepting the property subject to the debt obligation decreases the likelihood that such transactions could occur on a routine basis. Moreover, in the real world sometimes parties need the flexibility to encumber property immediately prior to a transfer in order to ensure that the divvying up of value is equal, which is an irrelevancy in the context of corporate reorganization exchanges. 78 that the Davis approach be abandoned in the context of divorce. The approach essentially would allow the pre-1984 treatment that applied to equal divisions of community property in community-property states to apply to all transfers of property in divorce: The transferor would not recognize the built-in gain or loss embedded in the property at the time of divorce, and the transferee would take the same basis in the property that it carried in the hands of the transferor. Any built-in gain or loss would thus be preserved in the hands of (and shifted to) the transferee. Under the "private-ordering" concept, the Task Force did not oppose the possibility that taxpayers be given the choice to "elect out" of nonrecognition treatment (with an ensuing fair market value basis in the hands of the transferee) under Davis, though it did recommend that, if taxpayers are given that option, the election should be on an "all-or-nothing" basis, with no ability to cherry pick which assets would fall under the nonrecognition/carryover basis regime and which would fall under the recognition/fair market value basis regime. 79 Second, the Task Force recommended amending I.R.C. §§ 71 and 215 in a number of ways. It recommended that the inclusion/deduction system be limited to cash payments so that in-kind property transfers could no longer be deductible as “alimony" by the transferor and [A]t the time of marital split-ups assets are frequently not in the most divisible form. For example, if a couple owns $400,000 worth of property, none of which is in the form of cash or cash equivalents, the new rules would permit the couple to encumber the property with a $200,000 liability and then allocate in a nonrecognition transaction the encumbered property (now with a net value of $200,000) to one spouse and the new cash to the other spouse. Task Force Technical Memorandum, supra note 73, at 10. I therefore think that the Task Force's recommendation to ignore debt encumbrances in deciding whether in-kind property transfers ought to be taxable events in divorce is defensible. Divorce, where the parties are attempting to divvy up property between them, really is different, in a fundamental way, from corporate reorganizations, where the parties are attempting to continue their ownership in transferred property indirectly via stock ownership. Nevertheless, Congress amended I.R.C. § 1041 in 1986 to provide that transfers of encumbered property to a trust will result in gain recognition to the extent that the debt exceeds the transferor's basis. It also provided that transfers of installment obligations to a trust would result in gain recognition. See Tax Reform Act of 1986, P.L. 99-514 (1986). While there is no legislative history underlying these changes, presumably transfers in trust, as opposed to direct transfers, were thought to raise the potential for abuse. 78 It made no recommendations with respect to transfers of property during marriage that are not incident to divorce. When enacted, however, I.R.C. § 1041, which substantially adopts the Task Force's nonrecognition recommendation, was made to apply to transfers during marriage as well, whether gifts or sales for consideration. See infra note 301 (considering whether application of I.R.C. § 1041 ought to be limited to the divorce context). 79 See Task Force Technical Memorandum, supra note 73, at 11. Cf. Gabinet, supra note 77, at 31-37 (questioning whether the parties ought to be able to decide whether a transfer is a taxable or nontaxable event under the concept of “private ordering"). See infra note 250 and accompanying text (defending the current rule mandating nonrecognition in all in-kind transfers). 80 81 includable by the transferee.' It also recommended that the "periodic" and "support" requirements, as well as the "principal sum" rules, be eliminated. Most important, it recommended that the parties be given the freedom (with the exceptions noted below) to designate how much, if any, of such cash payments (including cash payments to third parties on behalf of a spouse) would be includable by the payee and deductible by the payor. Any portion of any payments that were not specifically designated by the parties as being includable by the payee and deductible by the payor would be excludable and not deductible. The private-ordering elections would be respected, regardless of whether or not any contingencies--such as the death or remarriage of the recipient spouse or the ability of a state court to alter awards based on changed economic circumstance--would increase, decrease, or terminate any of the payments in the future.82 Therefore, there would, in the view of the Task Force, be little or no need to resort to litigation to determine whether or not a payment fell within the inclusion/deduction system of I.R.C. §§ 71 and 215. Under private ordering, the parties' explicit choice as to the income tax treatment for their "Section 71 package" would apply irrespective of whether any or all payments are explicitly restricted for child support or whether any contingencies might increase, decrease, or terminate any of the payments in the future. Moreover, the parties could agree to different treatment for different components of their "Section 71 package." For example, they could designate all of the intended spousal support as" includable/deductible and all of the intended child support as “excludable/nondeductible" or vice versa. As another example, the parties might agree to a percentage arrangement, e.g., 30% of the husband's compensation income going to the ex-wife, cast in the traditional unallocated form, but nevertheless designate that the first $1,000 per month would be "includable/deductible," with all payments in excess of this amount as "excludable/nondeductible." Further, if the parties choose, the safe-harbor designations could also cover certain types of cash payments to third parties, such as payments for education, medical costs, or life insurance premiums.' 83 The Task Force did not see a need to specifically deal with child support, since it believed that the Lester Rule then in force already provided "private ordering," in that any nonallocated "family support" payment would automatically be considered a potentially includable/deductible payment (if so designated by the parties under the proposed system). In contrast, a payment specifically "fixed" for child support would remain the means by which the parties could "elect" to make a payment excludable/nondeductible. Therefore, the Task Force made no recommendations to change the child support rules. In connection with the above proposals, it should be noted that the Task Force contemplates no basic change to the existing child support rules of Section 71(b). Payments 80 See Task Force Technical Memorandum, supra note 73, at 17. 81 Id. 82 Task Force Preliminary Specifications, supra note 73, at 3. 83 Task Force Technical Memorandum, supra note 73, at 12. |